Asset allocation software attempts to automate the process of deciding upon a range of investments for an overall sum of money. It can be used by, or as a replacement for, professional fund managers. As with any computer application, asset allocation software only works as well as is possible given the way it is set up and customized.
The main use of asset allocation software is when an investor or fund manager is seeking to find the best mix of investments. This is usually done by dividing different investments into financial asset classes. These rank the investment types by their security. For example, a bond issued by a stable government is normally considered virtually risk free, while the riskiest investments include mezzanine stocks in struggling or less-established companies. As a general rule, the riskier the asset class, the higher the return — if, of course, the return is delivered.
It's possible to carry out asset allocation on a purely manual basis. At it's very simplest, putting half an investor's money into high-return risky assets and half into low-return, more secure assets is a form of asset allocation. In practice though, many investors want to carry out a much more sophisticated form of allocation that requires a computer program to deal with the different possibilities.
As well as simply dealing with asset classes, asset allocation software can also work with specific investments. For example, two government bonds may offer a different interest rate, and the investor may also want to take account of the potential revenue from selling the bond on to another investor before it is due for redemption. Stocks, of course, vary immensely from one another, with investors needing to take account both of past performance and of volatility.
The key to effective asset allocation software is to offer users a balance of simplicity and flexibility. A good package will allow the user complete control over what variables he wishes to tweak to experiment with different results. At the same time, it will also allow him to get results as quickly as possible by automating the process.
Many asset allocation software products include a backtesting feature. This allows the user to see how a particular portfolio line-up would have performed over a period in the past. While potentially very useful, this has two major caveats: users should always remember that past performance does not guarantee future results; and users should be very wary of any backtesting that is portrayed as proving the skills of a particular investor or fund manager.